Where’s the Chinese Toyota?

If China is going to build on its growth, it's going to need an industrial policy that backs it up instead of holding it back.

The common perception of China relying on industrial policies to make its economy successful is just an illusion," says Fan He, assistant director of the Institute of World Economics and Politics at the Chinese Academy of Social Sciences. "If industrial policy works, it’s mainly at the local level."

Industrial policy is sometimes shorthanded by its critics as "picking winners" — essentially, it’s government intervention to build certain industries by offering incentives and shielding them from foreign competition. Japan’s industrial policy of the 1970s and 1980s, which was later copied by South Korea and Taiwan, is among the most studied recent examples. But if the goal of traditional industrial policy is to invest in companies and turn them into global dynamos, China has a long way to go. More than half of Chinese exports are made by companies with significant foreign investment. Although Lenovo and Haier have made laudable strides overseas, Beijing has yet to produce a truly international brand along the lines of Japan’s Sony or Toyota. And it has struggled to consolidate its automotive, steel, aluminum, and coal-mining industries.

Take cars, for instance. Although the government has been guiding the development of the automotive sector for at least two decades, more than 80 percent of industry revenues still come from joint ventures where the management expertise and technology is provided by foreign companies such as Shanghai Volkswagen, FAW-Volkswagen, and Shanghai GM, according to Arthur Kroeber, managing director of the consultancy Dragonomics. Despite government support for state-owned enterprises, the most-aggressive, fastest-growing automotive companies in China are the independents — companies with entrepreneurial leaders like Chery, Geely, Great Wall, and BYD, says Bill Russo, senior advisor at Booz & Co.

It’s not that Beijing has done everything wrong. For one, its tight management of the currency has enhanced its global competitiveness, to put it mildly. The government has also managed to keep costs down for manufacturers by offering cheap capital through the banks and allowing state-run companies to dominate key sectors such as telecommunications and electrical-power generation.

But currency control and cheap capital do not a winning industrial policy make. Since the 1980s, the overarching goal of Chinese industrial policy has been rapid economic growth through industrialization — a strategy that mirrors those of South Korea and Japan in earlier years. Like its neighbors once did, China singles out strategic industries, including the automotive, semiconductor, aerospace, oil, and petrochemicals sectors, sets goals for their development, encourages banks to provide financing, and introduces policies to encourage their growth, including those on foreign investment. These policies essentially send a message to industry: Here’s what we want to promote.

"China’s industrial policies are mainly trying to balance between different sectors," explains He of the Chinese Academy of Social Sciences. But what sets China apart is the way it has implemented this policy. Where South Korea and Japan ruled from the top, in China, industrial policy is decentralized and sometimes even chaotic.

Jack Perkowski, a former Yale University offensive lineman who founded an automotive components company in China in 1994, compares traditional industrial policy with football: The coach drafts plays, and the players execute them. Chinese industrial policy is more like soccer: free-flowing. "It’s kind of the players on the field that are making up the rules, that are making up how the game is played, not the coach," he says. "The coach is staying on the sidelines hoping his team will win."

China’s official coaches do more than hope. The problem for everyone else is, it’s not always clear who they are. Unlike with Japan in the 1960s and 1970s, where the leadership of the Ministry of International Trade and Industry was well established and industrial-policy watchers had a good sense of who was pulling the strings, Beijing-watchers are still debating who actually makes Chinese industrial policy, in part because of a lack of transparency in the policymaking process, but also because people in so many parts of the government seem to have a say. The National Development and Reform Commission, a government agency that is part of the State Council and oversees economic development, obviously plays a role, but other government departments weigh in as well.

What is clear is that foreign direct investment, private entrepreneurs, and local government initiatives, rather than traditional industrial policy, are key drivers of economic growth. Southern China’s Pearl River Delta is one good example. Starting in the 1980s, regional authorities used incentives like preferential tax rates and discounts on land to lure foreign investors, many of them from Hong Kong and Taiwan, to the region, which was then farmland. Beijing did establish special economic zones to serve as incubators of capitalism, but it also loosened the reins by giving the region more freedom to set its own wages and prices.

Foreign investors provided jobs and technology to local firms through joint ventures. Other times, local firms illegally copied or reverse-engineered foreign technology. Wages stayed low because workers were coming in constantly from the countryside and local officials didn’t enforce labor laws consistently. Private entrepreneurs poured into the region, creating a competitive frenzy that produced prices so unbeatably low they became known simply as "the China price."

Today, the delta is the world’s largest consumer electronics production hub, an agglomeration of factory towns to end all other factory towns. Home to the world’s largest plant with some 270,000 workers, a prominent electric car producer, and the country’s largest telecommunications equipment company, it produces a third of China’s exports.

But the delta’s success is just one element of China’s industrial policy. Elsewhere, China has used foreign investment as a shield to protect domestic companies. By limiting ownership in car assembly operations to 50 percent, China allowed its companies access to foreign technology while guarding them from the full force of international competition — a strategy Eric Thun, a lecturer at Oxford University, calls "industrial policy on the cheap." According to the Chinese government’s road map, however, the foreign joint-venture partners should have provided their Chinese counterparts the technology and management savvy to produce best-selling cars under their own brands. So far, that hasn’t happened.

But the problem runs even deeper than that: Current industrial policy isn’t making the Chinese economy more balanced, which is precisely what Beijing and the rest of the world want to see happen. China’s industrial policy, like Japan’s over the past three decades, favors people who make things over those who consume them. The People’s Bank of China keeps interest rates low to provide financing for producers, at the expense of households, whose effective return on deposits over the past decade has been a measly 0 to 2 percent, according to Daniel Rosen, principal of New York-based consultancy Rhodium Group. China’s industrial policy "takes care of borrowers, but what about the people whose money it is in the first place?" Rosen asks. This adds to the imbalances in both the Chinese and global economies by making Chinese consumers worse off, so they’re more likely to save their money instead of spending it. By the same token, limited wage growth in areas like the Pearl River Delta enhances China’s competitive advantage as an exporter, but it, too, hinders growth in consumer spending. Low interest rates also exacerbate many industries’ overcapacity problem by making it cheap for manufacturers to borrow.

As Beijing tries to redirect its economy away from labor-intensive exports toward one that relies more on high technology and domestic consumption, it will have to find good answers to questions like Rosen’s. Going forward, it will be crucial for China to relax its grip over sectors such as health care, education, and telecommunications and channel more loans to private companies. And perhaps, as Massachusetts Institute of Technology’s Yasheng Huang and others argue, China needs to allow its currency to appreciate not only to stop distorting its economy and global trade balances, but also to encourage innovation.

As for all those Beijing-watchers falling sway to the current fascination with all things China and contemplating making a little industrial policy of their own, the relevant lesson is clear: Better look under the hood first.